Initiating Coverage of Cipher Pharma

We are initiating coverage of Cipher Pharmaceuticals Inc. (DND.TO, T.DND) with an ‘Outperform’ rating and $2.25 price target, or a market capitalization of $50 million. Cipher currently trades with a market capitalization of only $16 million. We believe the story is largely de-risked and under-appreciated by the Street. Cipher currently has two revenue streams in place with royalties and milestones on sales of Lipofen (CIP-fenofibrate) at Kowa Pharma in the U.S. and the recently launched ConZip (CIP-tramadol-ER) at Vertical Pharma in the U.S. We expect a third royalty and milestone stream from the launch of Durela (CIP-tramadol-ER) at Medical Futures within the next few months.

We have established what we believe to be conservative forecasts for these revenue streams going forward to patent expiration on each product, Lipofen (Q1-2015) and ConZip/Durela (2022). We remind investors that Cipher has little to no ongoing costs associated with either product. Therefore, the best way to value these revenue streams is through the net present value (NYSE:NPV - News) of the cash flows using a 20% discount rate. We believe royalties and milestones on Lipofen are worth approximately $7 million in value. Royalties and milestones on ConZip / Durela are worth another $8 million in value. Finally, we forecast that Cipher will exit 2011 with approximately $9 million in cash and equivalents.

…CIP-Isotretinoin Offers Big Upside…

Based on our model, the stock is currently trading below the net present value of the cash flows from Lipofen and ConZip / Durela, plus the cash on hand. That means investors can purchase the stock today and get the CIP-Isotretinoin product, a potential $200 million opportunity in the U.S., for free. Cipher has licenses the rights to CIP-Isotretinoin to Ranbaxy, a major player in the generic Isotretinoin market with branded Sotret. Sotret posted U.S. sales over $120 million in 2008 prior to the FDA mandating a recall on the product due to quality control / GMP issues at the company’s plant in India. We believe that Cipher’s CIP-Isotretinoin, with its superior absorption and bioavailability characteristics will move into the primary detail position for Ranbaxy’s efforts around Isotretinoin.

Cipher is entitled to receive a mid-teens royalty on sales of CIP-Isotretinoin at Ranbaxy, along with the potential for $19 million in milestones ($9 million upon approval and two $5 million cumulative sales related) with roughly 50% economics to Cipher after it pays the sub-royalty to Galephar.

Cipher becomes a different company with CIP-Isotretinoin on the market in the U.S. By 2016, the royalties on CIP-Isotretinoin alone will account for greater than 80% of the top-line.

We also remind investors that Cipher has filed an application for approval with Health Canada. We estimate the Canadian opportunity with CIP-Isotretinoin is around $10 million, and we expect that Cipher will seek to commercialize the drug on its own through the formation of a small internal sales force of 6 to 8 representatives. We assume Canadian approval in mid-2013.

…Keep Risks In Mind…

Approval of CIP-Isotretinoin is paramount to our investment thesis. The application is not without risks however. The U.S. FDA has rejected Cipher’s NDA on CIP-Isotretinoin twice in the past five years. The second letter called for Cipher to conduct a phase 3 safety trial, which Cipher completed and presented data on in June 2011.

Of the 925 patients who enrolled in the study, 813 patients completed the 20-week trial. The safety data revealed no overall statistical differences in the adverse event profile or the pharmacokinetics between CIP-Isotretinoin and a commercially available generic Isotretinoin product. Unfortunately, the efficacy component offers mixed results. The efficacy component of the study had two co-primary endpoints: 1) the total change in lesion counts between baseline and at the end of week 20; and 2) the total number of subjects that had at least a 90% clearing at the end of 20 weeks of treatment. These two co-primary endpoints were analyzed using the per-protocol population (:PP) as well as the intent-to-treat population (NYSE:ITT - News) last observation carry forward (:LOCF).

In the PP analysis, both co-primary endpoints met the non-inferiority margins established for the study. In the LOCF analysis of the ITT population, the first primary endpoint (total change in lesion count) was achieved while the second endpoint (at least 90% clearing) fell narrowly (less than 0.5%) outside the non-inferiority margin target. However, we do not believe this will be an issue to hold up approval in the U.S. We think the FDA was far more interested in the safety analysis from the trial. The trial was set up as a safety and PK analysis. The FDA has traditionally approved reformulations in the past on PK / bioavailability data alone. Cipher went above and beyond a traditional reformulation application by conducting the extensive safety analysis requested by the agency. However, a missed endpoint presents risk, and this is the single biggest risk to owning the stock ahead of the May 29, 2012 U.S. FDA PDUFA action date.

DCF Model Shows Fair-Value at $2.25

We have conducted a discounted cash flow (:DCF) analysis to value the shares of Cipher Pharmaceuticals Inc. Above we note that our NPV / Sum-of-Parts analysis for the cash flow from Lipofen and ConZip / Durela alone shows a market value of $23.8 million. However, this is just to give investors a sense of the downside to the Cipher story. At today’s value, the stock is trading on the present value of these cash flows. We see little downside in the stock price as long as Lipofen and ConZip / Durela meet our forecasts.

Upside comes with the approval of CIP-Isotretinoin. Cipher will receive a net $4.5 million cash payment from Ranbaxy if the U.S. FDA approves CIP-Isotretinoin. Our model (posted below) shows that operating cash flow should turn positive immediately after the approval of CIP-Isotretinoin. That means that by the end of 2012, Cipher could be collecting revenues from three approved products in the U.S., with a growing cash balance of over $10 million in the bank, and generating positive cash flow. We think that this presents the clear opportunity to in-licenses yet another 505(b)(2)-like product for late-stage development and commercialization in 2013. We would be buyers of Cipher’s stock today, ahead of what we see as a transformational 2012 coming with the potential approval of CIP-Isotretinoin. Our rating is ‘Outperform’.

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